QVMM - Will Markets Stay Irrational In 2024?
2023-11-20 21:25:00 ET
Summary
- Over the past year, the S&P 500 has rallied by almost 20 percent despite very troubling underlying economic and political fundamentals.
- In the year ahead, the key question for investors is whether the markets will choose to continue ignoring those fundamentals and party as if there were no tomorrow.
- Among the more troubling fundamentals that the market is choosing to ignore is the fragility of the US and world financial system in a Federal Reserve-induced high interest rate environment.
John Maynard Keynes famously observed that markets can stay irrational for longer than you can stay solvent. By this, he meant to warn investors not to bet the ranch on markets going down because of weak underlying economic or political fundamentals.
From his own bitter experience, he had learnt that markets could choose to ignore even the weakest of fundamentals for longer than he could afford to maintain a short position.
If ever Keynes’s observation had validity, it has to be today. Over the past year, the S&P 500 has rallied by almost 20 percent despite very troubling underlying economic and political fundamentals.
In the year ahead, the key question for investors is whether the markets will choose to continue ignoring those fundamentals and party as if there were no tomorrow.
Among the more troubling fundamentals that the market is choosing to ignore is the fragility of the US and world financial system in a Federal Reserve-induced high interest rate environment.
This is all the more surprising considering that today the world is more indebted than it has ever been before.
It is also surprising given the early warning signs of financial strain that we have had this year. In March, we had a regional banking crisis following Silicon Valley Bank’s failure.
That crisis required large scale Fed intervention to prevent large uninsured depositors from running on the banks. More recently, we have had a spike in the all-important 10-year Treasury bond yield to five percent as the bond market vigilantes have become increasingly concerned about an eight percent of GDP US government budget deficit at a time of cyclical economic strength.
Another economic fundamental to which the markets are turning a blind eye is the slow-motion train wreck occurring in the commercial real estate sector.
Never mind that property developers will have considerable difficulty in rolling over the estimated $500 billion in property loans that fall due next year.
They will struggle because they have to contend with unusually high vacancy rates in a post-COVID world and very much higher interest rates than those at which they initially contracted their loan.
Never mind too that a wave of commercial real estate loan defaults would upend the regional banks that are heavily exposed to such loans.
On the external economic front, markets are being excessively complacent about trouble brewing in a number of key economies. China, the world’s second-largest economy and until recently its primary engine of economic growth, is now moving to a decidedly lower growth path.
It is doing so as a result of the bursting of its super-sized housing and credit market bubble. A Chinese economic slowing could spell real trouble for its Asian trade partners and for the commodity-dependent emerging market economies.
Meanwhile, Europe is slipping into a recession at a time when key countries like Italy are more indebted today than they were at the time of the 2010 Eurozone debt sovereign debt crisis. This is all the more worrying since Italy has an economy that is some ten times the size of Greece.
As if there were not enough economic issues about which to be concerned, we also have an unusually challenging geopolitical environment. We now have both a Russia-Ukraine and an Israel-Hamas war.
The World Bank is warning that if the latter war spilt over to the rest of the region, we could see international oil prices spike to $150 a barrel.
Meanwhile, US-China relations remain very strained and China keeps threatening to take action against Taiwan, the world’s main electronic chip producer.
Despite this unusually high wall of worry, it is entirely possible that markets will continue to behave next year as if there was no reason to be concerned.
However, investors would be well advised to remember the observation of Rudi Dornbusch, the late MIT economist.
He warned that economic and financial market crises take a lot longer to occur than you thought possible. However, when they do occur, they occur at a very much faster pace than you could have imagined.
Editor's Note: The summary bullets for this article were chosen by Seeking Alpha editors.
For further details see:
Will Markets Stay Irrational In 2024?